Unveiling the Dutch Disease Indexes: Principal Component Analysis in a Small Oil-rich Country

Abstract

The Dutch disease (DD) theory is a popular approach when analyzing the economies of resource-rich countries. However, despite the extensive examination of both the original DD theory and its variations in numerous country cases, the findings remain contradictory and inconclusive, primarily due to the challenges associated with measuring DD. Building upon the notable case study of the Azerbaijani economy, this paper introduces a novel way to utilise principal component analysis (PCA) in index development, which incorporates the modelling framework of the original theory and provides a profound understanding of DD measurement. The findings of the study reveal that the fundamental variables associated with DD in the Azerbaijani economy can be effectively condensed into a small number of principal components (PCs). In addition, this research introduces not only a total Dutch disease index (TDDI), but also a resource movement index (RMI) and a spending index (SI), with the last of these demonstrating a more pronounced impact in Azerbaijan. The estimated indexes exhibit a significant and negative correlation with the manufacturing sector’s share in the industry, pointing to the presence of the crowding-out mechanism of DD. Moreover, a strong positive correlation is observed with key growth indicators such as gross domestic product (GDP) and gross capital formation, underscoring the exceptional role of the oil boom in the Azerbaijani economy. These findings justify the contention that DD is present in the Azerbaijani economy. The paper also provides a composite index that can be utilised by both policymakers and scholars for measuring DD.